Investors move into large-caps

In December, our outlook for the coming 12 months touched on the fact that both small and mid-cap stocks had done extremely well and we suggested that 2014 may well see large and mega-caps do better. That rotation seems to have started with large-caps returning just over 3% year to date, whilst small and mid caps have struggle to reach 1%*.

Richard Buxton, manager of the Old Mutual UK Alpha fund, and Richard Marwood, manager of the AXA Distribution fund give their thoughts on whether this size rotation will continue.

Richard Marwood begins: “There has been a big shift in sentiment within equity markets since the beginning of the year. While markets have broadly remained flat, there has been a rotation of performance from the small and mid-caps to mega caps.

“In addition, corporate activity has drifted up the market-cap scale. It is commonplace to see bid activity for smaller companies, but we are increasingly seeing bids being made for larger companies, such as Verizon’s takeover of Vodafone. We expect much more bid activity in the remainder of 2014 and also a high level of new issues through IPOs if the equity market is firm.”

Richard Buxton adds: “What is driving the rotation away from mid and small-cap stocks to the previously unloved mega-cap stocks – is it a temporary rotation or the start of something more profound and long-lasting?

In fairness, the valuation stretch between the mega-cap stocks and the rest of the market
had reached levels by the end of 2013 from which there was always likely to be some snap-back. The catalyst within the market seemed to be the bursting of the hot momentum sectors – notably tech and biotech in the US, alongside some highly questionably priced IPOs here in London. The bursting of this bubble quickly spread to a ‘take profits’ mentality in anything which had performed strongly in recent years, which inevitably meant many mid and small-cap stocks, domestically-sensitive and cyclical shares.

Is this purely a market and investor positioning issue, or is it reflective of deeper economic concerns? Whilst data from China has remained weak, the US does appear to be shrugging off the effects of winter and job growth remains positive. The UK is clearly in a strong recovery phase, although the European Central Bank is flagging the need for more stimulus in Europe.

Without doubt, the post-financial crisis healing process is not over yet. But with the levels of economic growth likely to be delivered this year and next in the US and UK, it is difficult to believe that activity has peaked and is rolling over, or that corporate profits will fall from here. Corporate confidence is improving, as witnessed by improved hiring, rising job vacancies and higher levels of M&A activity.

More likely current market moves reflect prior investor positioning and sentiment. Trouble was expected in the bond market this year as US Federal Reserve tapering continued – instead the impact has been felt in crowded and illiquid equity positions. The shake-out is testing those, like myself, of a generally benign and bullish outlook, as bull markets always ‘climb the wall of
worry’. It is creating opportunities to add to favoured holdings at attractive levels. It rightly forces you to re-examine your views and convictions, but I remain of the view that this is more of a market and positioning issue than anything more sinister.

*Source: FE Analytics, total return, bid-bid, 31st December 2013 to 28th May 2014.